Storm is brewing for cloud-computing stocks

Investors are all abuzz over cloud computing, which allows individuals to access services and applications via the Internet without maintaining their own servers and software. Even Sir Paul McCartney is a big fan: Last week, the legendary Beatle’s production company said that it was working with Hewlett-Packard Co. to digitize and deliver his music through a private cloud.

It is only logical that in a market environment so light on performance, investors would be drawn to what looks like a major evolution in technology. But the investment outlook for many of the companies vying for a piece of this market is hazy at best.

And as stock prices shoot into the stratosphere, the frothy environment is beginning to resemble the tech bubble of the late 1990s. Financial advisers should be wary.

A common example of how cloud computing works is the way that Yahoo Inc. and other companies provide free e-mail service that is supported by advertising. What has the investment community most excited is the development of private clouds for specific companies and industries.

Salesforce.com Inc. (CRM), which offers an online customer relationship management platform, is a good example of how the market is chasing the cloud-computing craze to ridiculous levels. Salesforce is successful and profitable, and its service can be delivered effectively through a web-based model, which represents one of the many broad definitions of cloud computing.

But with the stock at more than $120 a share, up more than 68% from the start of the year and trading at nearly 220 times its earnings, Salesforce has become a poster child of the cloud-computing bubble.

Another example is Open Table Inc. (OPEN), a web-based business that coordinates reservations for multiple restaurants. The stock, at more than $65 a share, is up nearly 160% from the start of the year and is trading at 171 times earnings.

“The concept of cloud computing is here to stay, but you have to be rational about it, and it appears that the market has become overly optimistic,” said Sunit Gogia, a senior equity analyst at Morningstar Inc.

Although it is true that the continued development of cloud computing will require increased bandwidth, new hardware and software systems, the market so far has been essentially indiscriminate in its thirst for cloud-computing investments.

Rackspace Hosting Inc. (RAX), a company that manages web-based information technology systems, could be considered a cloud-computing pure play, a concept that isn’t lost on the market. Rackspace’s stock is up more than 10% so far this year, but at $23 per share, it is trading at more than 80 times earnings.

“This is another company that has been taken up in the cloud-computing wave,” said Harry Rady, chief executive of Rady Asset Management LLC, which manages $270 million in long/short portfolios.

As Mr. Rady sees it, much of the development in cloud computing relates to bringing existing and commodity technologies together, which makes many of the industry participants extremely vulnerable to competition.

While he appreciates the benefits of outsourcing hardware and technology to a company such as Rackspace, Mr. Rady said the company is still providing a commodity service with no competitive edge.

“Cloud computing will quickly mature and get competitive, and that’s when the margins will get squeezed,” he said. “These aren’t products with monopolies, and they’re operating in a market with very low barriers to entry.”

More than a quarter of the stock in Rackspace is being sold short, which actually tilts the risk toward the short side because a sudden rally could lead to a short squeeze.

That’s not to say that cloud computing isn’t here to stay. But too many of the valuations on companies in this space have become otherworldly and loaded with risk.

For advisers looking for exposure to cloud computing, it makes more sense to focus on some of the larger, more diversified technology companies such as Google Inc. (GOOG), Microsoft Corp. (MSFT) and Yahoo.

Another way to gain indirect and diversified exposure would be through a targeted exchange-traded fund, such as Technology Select Sector SPDR (XLK) or iShares Dow Jones U.S. Technology (IYW).

“There’s no need to pay 100 times earnings to gain exposure to cloud computing,” Mr. Rady said. “You can see how quickly the space is getting crowded and frothy; this is going to end badly.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].